Lenders put Volcker rule to test in lawsuit

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The banks have fired their first salvo in what could soon turn into a war of litigation over the Volcker Rule.

As expected, the American Bankers Association, an industry trade group, filed a motion in federal court in Washington on Tuesday seeking to quickly suspend one part of the two-week-old Volcker Rule. The group claims 275 small banks will suffer an imminent $600 million hit to capital and make them less likely to lend to consumers and businesses.

Although the current dispute centers on an obscure and complex investment product, the association’s lawsuit could become an early test of how much the industry can successfully push back against the Volcker Rule. The rule was devised to stop regulated banks from speculatively trading with their depositors’ money and other funds in an effort to avoid some of the problems that led to the bank bailouts following the 2008 financial crisis.

Banks have long been lobbying to shape or water down the Volcker Rule. After much delay, five federal agencies approved the final rule this month, bolstering some provisions but leaving others open to loopholes.

The lawsuit is an indication of how far banks may be willing to go to challenge regulators in court, even if the total dollars at issue are relatively few. And, ironically, the first legal assault is being brought on behalf of smaller banks, not big Wall Street firms like Goldman Sachs or JPMorgan Chase, which had until recently engaged in some of the speculative trading that the Volcker Rule mainly targeted.

Even before the Volcker Rule became law, some were predicting Wall Street would head to court to oppose provisions it did not like, including a measure that would curtail the ability of banks to engage in portfolio hedging, a type of trading that critics say goes beyond normal hedging of positions for either the benefit of clients or the mitigation of the bank’s own risk.

At the heart of the bankers group’s lawsuit are instruments called collateralized debt obligations, the instruments that helped stoke the financial crisis. The final Volcker Rule contained language that, to many in the industry, seemed to prohibit banks from holding CDOs.

The banking association says the Volcker Rule unfairly targets a special type of CDO held by smaller banks. These instruments are made up of so-called trust-preferred securities, a cross between a bond and a stock that banks issued to increase their capital.

Crucially, accounting rules have shielded banks from taking a full hit on these soured investments. But the banks could lose that shield if the Volcker Rule forces them to offload the CDOs. As a result, the banking association argues that the banks might have to take big write-downs in the next few weeks that would substantially dent their capital.

It’s too soon to say how the litigation will play out and whether the trade group will get a quick stay of the measure, especially because bank regulators issued guidance last week that had sought to allay some of the banking industry’s concerns that the Volcker Rule amounted to a blanket ban on trust-preferred CDOs.

A spokesman for the Federal Reserve, one of three regulatory agencies sued by the industry group, along with the Federal Deposit Insurance Corp. and the Office of the Comptroller of the Currency, said the regulators need to review and confer on the lawsuit before commenting.

Banks have until July 21, 2015, to divest themselves of risky assets under the Volcker Rule but can get an extension from the Fed if necessary.

The issue of whether the Volcker Rule is intended to force banks to divest themselves of trust-preferred CDOs has been gathering momentum since Zions Bancorporation, a regional lender based in Salt Lake City, said Dec. 16 that it was taking a $387 million fourth-quarter charge to write down the value of its portfolio of the securities and was reducing its regulatory capital levels after changing its accounting treatment for those securities.

Audit firms have been telling some bank clients that without more specific guidance from regulators, banks cannot avoid writing down the CDOs, potentially forcing the banks to absorb capital hits by the end of the year.